Suppose that our fire department was staffed with out-of-shape incompetents who didn’t know how to handle a fire hose. That would be really bad news, but it wouldn’t be obvious most of the time because we don’t often see major fires. The inadequacy of the fire department would become apparent only when a major fire hit and we were left with a vast amount of unnecessary death and destruction. This is essentially the story of modern economics.
The problem is not that modern economics lacks the tools needed to understand the economy. Just as with firefighting, the basics have been well known for a long time. The problem is with the behavior and the incentive structure of the practitioners. There is overwhelming pressure to produce work that supports the status quo (i.e. redistributing to the rich), that doesn’t question authority, and that is needlessly complex. The result is a discipline in which much of the work is of little use, except to legitimate the existing power structure. In terms of the poor quality of work, it is easy to point to the failure to recognize the size and risks posed by the housing bubble in the last decade. This failure has been unbelievably costly to the United States and the rest of the world. If we compare the most recent estimates of the potential GDP of the U.S. economy from the Congressional Budget Office (CBO) with the projections made in 2008, before the severity of the crash was recognized, the difference is $1.8 trillion. This is an annual figure; it implies a loss of $18 trillion over the course of the decade. This amount averages out to more than $54,000 for every person in the country. Other countries have seen even larger losses.
CBO is not God, so it could have been overly optimistic before the crash and is arguably too pessimistic at present. But even if we cut the number in half, we are still looking at a loss of $9 trillion over the course of a decade, or $27,000 per person. It is also worth noting that CBO’s numbers are useful here not only because they are seen as authoritative, but they are in the center of the profession by design. CBO raises or lowers its numbers if they are out of line with the consensus of economic forecasters.
The retrospective analyses of the overall crash have focused on the financial crisis specifically. These analyses have worked hard to convince people that seeing an impending financial crisis is an extremely difficult undertaking, but the reality is that the financial crisis was very much secondary. The overwhelming reason for the downturn and the weak recovery was the collapse of housing bubbles in the United States and elsewhere that were driving growth.
It was not difficult to recognize these bubbles. House prices had risen at an unprecedented pace in the years from the mid-1990s until the crash, with no remotely plausible basis in the fundamentals of the housing market. This could be seen by a variety of measures, but most obviously from the fact that rents were still following the overall rate of inflation, as they ordinarily do. The record vacancy rate—even before the crash—might also have been a red flag, especially to people who believe in supply and demand determining prices.
Also, the fact that housing was driving the economy was clear from the record share of residential construction in GDP, as well as an unprecedented consumption boom driven by housing wealth. Of course these sources of demand would disappear when the bubble burst; what could anyone expect to replace 6 percentage points of GDP in annual demand (around $1.1 trillion in today’s economy)?
When I tried to raise these issues in years prior to the crash, my arguments were largely laughed off by a wide range of economists. I didn’t have the stature, and besides, the argument was far too simple. This is not the first time that I had a problem with making arguments that were too simple.
Back at the time of the debate over President Bush’s Social Security privatization plan, I pointed out that his Administration’s assumed rates of return in the stock market were impossible given the current price-to-earnings (P/E) ratios in the market and the economic growth rates assumed by the Social Security trustees. This was an argument based on simple algebra.
Brad DeLong wanted to make this into a Brookings paper and enlisted Paul Krugman in the effort. Together they produced a paper (generously leaving me as lead author) that had an intertemporal optimization model with declining labor force growth as its key feature. (You don’t have to know what an intertemporal optimization model is; just that it added complexity.) This model had nothing to do with the underlying point (the stock market would yield the assumed returns if its price-to-earnings ratio was near its historic average of 15, rather than the P/E level near 25 that we were seeing at the time), but it was necessary to have something more complex than simple algebra to be taken seriously at Brookings.
It is easy to extend the list of failings in the economics profession. It is just now becoming accepted that our pattern of trade imposes substantial costs on large segments of the working population. This didn’t require any new or novel innovations. This is a prediction of the completely mainstream Stolper-Samuelson theorem, first published three-quarters of a century ago.
And why is there so little research devoted to analysis of alternatives to patent financing of prescription drug research? The mark-ups associated with patent protection in the sector are equivalent to tariffs of many thousand percent. Every competent economist knows that a gap that large between a government-protected price and a free-market price is a recipe for massive waste and corruption. The gap between patent-protected drug prices and free-market prices is now approaching $400 billion a year in the United States alone (more than 2 percent of GDP). This doesn’t require new economic thinking; it requires economists who know introductory economics.
And how about a little accountability for economists when they mess up? There is a large literature on the importance of being able to dismiss workers who do not perform their jobs well. We all know and expect that a dishwasher who keeps breaking the dishes or a custodian who can’t clean the toilets loses his job.
I have suggested that economists who prescribe policies that turn out badly, or who can’t see multi-trillion dollar housing bubbles coming whose collapse sinks the economy, ought to pay a price in terms of their careers. Invariably people think I am joking. When they realize I am serious, they think I am crazy or vindictive.
Leaving aside motives, let me just speak to the economics. If we have a profession in which people are rewarded with high pay and career advancement for saying the same thing as everyone else, and never face any consequences when the accepted wisdom proves to be wrong, then we should expect to see economists like the firefighters mentioned at the beginning of this piece. They aren’t qualified to do the job and our only hope is that we don’t see any more major fires.